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Statements for
Profitability, Liquidity,
and Solvency
Chapter 8
Financial
Financial statements
statements analysis
analysis isis the
the process
process
of
of looking
looking beyond
beyond the
the face
face of
of the
the financial
financial
statements
statements to
to gain
gain additional
additional insight
insight
into
into a
a companys
companys financial
financial health.
health.
Ratio
Ratio analysis
analysis is
is a
a technique
technique for
for analyzing
analyzing
the
the relationship
relationship between
between two
two items
items from
from a
a
companys
companys financial
financial statements
statements for
for aa given
given period.
period.
Stockholders
Stockholders equity
equity
Paid-in
Paid-in capital:
capital:
Common
Common stock,
stock, $10
$10 par
par value,
value,
100,000
100,000 shares
shares authorized,
authorized, 4,000
4,000
shares
shares issued
issued and
and outstanding
outstanding $
$ 60,000
60,000
Paid-in
Paid-in capital
capital in
in excess
excess of
of par
par
common
common stock
stock 4
4
Total
Total paid-in
paid-in capital
capital $10
$10
Retained
Retained earnings
earnings 5
5
Total
Total stockholders
stockholders equity
equity
Total
Total liabilities
liabilities and
and stockholders
stockholders equity
equity
Profitability
Profitability is
is the
the ease
ease with
with which
which
a
a company
company generates
generates income.
income.
Profitability
Profitability ratios
ratios measure
measure a a firms
firms
past
past performance
performance andand help
help predict
predict
its
its future
future profitability
profitability level.
level.
This
This ratio
ratio measures
measures how
how efficiently
efficiently the
the
company
company uses
uses its
its assets
assets to
to produce
produce profits.
profits.
Return
Return on
on assets
assets =
=
Net
Net income
income before
before taxes
taxes
Total
Total assets
assets
$105,301
$105,301
$288,015
$288,015 =
= 36.56%
36.56%
This
This ratio
ratio measures
measures the
the percentage
percentage of
of
income
income before
before income
income taxes
taxes produced
produced
by
by a
a given
given level
level of
of revenue.
revenue.
Profit
Profit margin
margin before
before income
income tax
tax =
=
Net
Net income
income before
before taxes
taxes
Sales
Sales
$105,301
$105,301
$527,146
$527,146 =
= 19.98%
19.98%
2005 Accounting 1/e, Terrell/Terrell 8 - 11
Profitability Ratios
This
This ratio
ratio calculates
calculates the
the amount
amount ofof sales
sales
produced
produced forfor a
a given
given level
level of
of assets
assets used.
used.
Total
Total asset
asset turnover
turnover ==
Sales
Sales Total
Total assets
assets
$527,146
$527,146
$288,015
$288,015 =
= 1.83
1.83 times
times
Return
Return on
on Profit
Profit margin
margin Total
Total asset
asset
assets = before income tax turnover
assets before income tax turnover
Net
Net income
income Net
Net income
income Sales
Sales
before
before taxes
taxes = before
before taxes
taxes Total assets
Total assets
Total
Total assets
assets
Sales
Sales
This
This ratio
ratio measures
measures the
the amount
amount ofof after-tax
after-tax
net
net income
income generated
generated by
by a
a dollar
dollar of
of sales.
sales.
Profit
Profit margin
margin after
after income
income tax
tax =
=
Net
Net income
income after
after taxes
taxes
Sales
Sales
$63,181
$63,181
$527,146
$527,146 =
= 11.98%
11.98%
This
This ratio
ratio indicates
indicates how
how much
much after-tax
after-tax income
income
was
was generated
generated for
for a
a given
given level
level of
of equity.
equity.
Return
Return on
on equity
equity after
after taxes
taxes =
=
Net
Net income
income after
after taxes
taxes
Stockholders
Stockholders equity
equity
$63,181
$63,181
$159,181=
$159,181= 38.69%
38.69%
This
This ratio
ratio calculates
calculates how
how much
much before-tax
before-tax income
income
was
was generated
generated for
for a
a given
given level
level of
of equity.
equity.
Return
Return on
on equity
equity before
before taxes
taxes =
=
(Net
(Net income
income after
after taxes
taxes +
+ Income
Income taxes)
taxes)
Stockholders
Stockholders equity
equity
$105,301
$105,301
$159,181=
$159,181= 66.15%
66.15%
2005 Accounting 1/e, Terrell/Terrell 8 - 16
Liquidity Ratios
An
An assets
assets liquidity
liquidity describes
describes the
the ease
ease
with
with which
which it
it can
can be
be converted
converted to
to cash.
cash.
Liquidity
Liquidity ratios
ratios evaluate
evaluate aa firms
firms ability
ability
to
to generate
generate sufficient
sufficient cash
cash to
to
meet
meet its
its short-term
short-term obligations.
obligations.
This
This ratio
ratio measures
measures thethe companys
companys ability
ability to
to
meet
meet its
its current
current liabilities
liabilities with
with current
current assets.
assets.
Current
Current ratio
ratio =
=
Current
Current assets
assets
Current
Current liabilities
liabilities
$190,637
$190,637
$83,834
$83,834 =
= 2.27
2.27 to
to 1
1
This
This ratio
ratio is
is a
a stringent
stringent test
test of
of liquidity
liquidity
that
that compares
compares highly
highly liquid
liquid current
current
assets
assets toto current
current liabilities.
liabilities.
Acid-test
Acid-test ratio
ratio =
= (Cash
(Cash +
+ Receivables
Receivables
+
+ Trading
Trading securities)
securities)
Current
Current liabilities
liabilities
($128,384
($128,384 +
+ $9,450
$9,450 +
+ $0)
$0)
$83,834=
$83,834= 1.64
1.64 to
to 1
1
2005 Accounting 1/e, Terrell/Terrell 8 - 19
Liquidity Ratios
This
This ratio
ratio indicates
indicates the
the level
level of
of sales
sales
generated
generated for
for a
a given
given level
level of
of working
working capital.
capital.
Net
Net sales
sales to
to working
working capital
capital =
= Sales
Sales
(Current
(Current assets
assets Current
Current liabilities)
liabilities)
$527,146
$527,146
($190,637
($190,637 $83,834)
$83,834) =
= 4.94
4.94 times
times
It
It measures
measures howhow quickly
quickly a
a company
company
collects
collects its
its accounts
accounts receivable.
receivable.
Accounts
Accounts receivable
receivable turnover
turnover =
=
Net
Net credit
credit sales
sales
Accounts
Accounts receivable
receivable
Net
Net credit
credit sales
sales =
= $151,650
$151,650 $2,426
$2,426 =
= $149,224
$149,224
Receivable
Receivable turnover
turnover =
=
$149,224
$149,224
$9,450
$9,450 == 15.79
15.79 times
times
Average
Average collection
collection period
period =
=
365
365
15.79
15.79 =
= 23.27
23.27 days
days
This
This ratio
ratio indicates
indicates the
the number
number of of times
times
total
total merchandise
merchandise inventory
inventory is
is purchased
purchased
(or
(or finished
finished goods
goods inventory
inventory is
is produced)
produced)
and
and sold
sold during
during a
a period.
period.
Inventory
Inventory turnover
turnover =
=
Cost
Cost of
of sales
sales
Inventory
Inventory
Inventory
Inventory turnover
turnover =
=
$295,834
$295,834
($4,397
($4,397 ++ $13,634)
$13,634) =
= 16.41
16.41 times
times
Average
Average number
number ofof days
days
Elevation
Elevation Sports,
Sports, Inc.,
Inc., holds
holds its
its inventory
inventory
=
= 365
365 16.41
16.41 = = 22.24
22.24 days
days
Solvency
Solvency is
is a
a companys
companys ability
ability to
to meet
meet the
the
obligations
obligations created
created by
by its
its long-term
long-term debt.
debt.
Solvency
Solvency ratios
ratios are
are of
of most
most interest
interest to
to
stockholders,
stockholders, long-term
long-term creditors,
creditors,
and
and company
company management.
management.
It
It measures
measures what
what proportion
proportion of
of a
a
companys
companys assets
assets is
is financed
financed by
by debt.
debt.
Assets
Assets =
= Liabilities
Liabilities +
+ Owners
Owners equity
equity
100% = Some % + Some %
Total
Total liabilities
liabilities
Total
Total assets
assets
$128,834
$128,834
$288,015
$288,015 =
= 44.73%
44.73%
This
This ratio
ratio is
is also
also called
called the
the
times-interest-earned
times-interest-earned ratio.
ratio.
It
It indicates
indicates aa companys
companys ability
ability to
to
make
make its
its periodic
periodic interest
interest payments.
payments.
Coverage
Coverage ratio
ratio =
=
Earnings
Earnings before
before interest
interest expense
expense
and
and income
income taxes
taxes
Interest
Interest expense
expense
($105,301
($105,301 +
+ $6,000)
$6,000)
$6,000
$6,000 =
= 18.55
18.55 times
times
This
This chapter
chapter emphasizes
emphasizes thethe Almanac
Almanac of
of
Business
Business and
and Industrial
Industrial Financial
Financial Ratios
Ratios..
The
The Almanac
Almanac includes
includes all
all
companies,
companies, public
public and
and private.
private.
Information
Information provided
provided in
in the
the Almanac
Almanac
for
for each
each industry
industry is
is four
four pages.
pages.
It
It consists
consists of
of two
two tables.
tables.
2005 Accounting 1/e, Terrell/Terrell 8 - 31
Industry Averages
Table
Table II provides
provides an
an analysis
analysis of
of all
all
companies
companies in in the
the particular
particular industry,
industry,
regardless
regardless of of whether
whether they
they had
had
any
any net
net income
income for
for the
the year.
year.
Table
Table IIII provides
provides the
the same
same information
information
items
items as as Table
Table I,
I, but
but it
it considers
considers
only
only companies
companies thatthat showed
showed
aa net
net income
income forfor the
the year.
year.
2005 Accounting 1/e, Terrell/Terrell 8 - 32
Learning Objective 4
Evaluate a companys
ratios
using a comparison to
industry averages.
Compare
Compare ratios
ratios to
to the
the industry
industry averages
averages
Look
Look for
for company
company trends.
trends.
Consider
Consider the
the industry
industry environment.
environment.
Draw
Draw conclusions.
conclusions.
The
The evaluation
evaluation process
process by
by nature
nature
depends
depends upon
upon individual
individual perception.
perception.
1.
1. Family
Family Dollar
Dollar Stores,
Stores, Inc.,
Inc., is
is an
an industry
industry
leader
leader in
in profitability
profitability and
and solvency.
solvency.
2.
2. Family
Family Dollar
Dollar has
has improved
improved the
the
distribution
distribution element
element ofof its
its supply
supply chain.
chain.
3.
3. Part
Part of
of the
the company
company profitability
profitability and
and
liquidity
liquidity will
will depend
depend upon
upon its
its increasing
increasing
the
the inventory
inventory turnover
turnover ratio.
ratio.
4.
4. If
If we
we choose
choose toto invest
invest in
in a
a general
general
merchandise
merchandise discounter,
discounter, Family
Family Dollar
Dollar
Stores,
Stores, Inc.,
Inc., might
might be
be one
one to
to consider.
consider.
1.
1. Attempting
Attempting to
to predict
predict the
the future
future using
using past
past
results
results depends
depends upon
upon the
the predictive
predictive
value
value of
of the
the information
information used.
used.
2.
2. The
The financial
financial statements
statements used
used to
to compute
compute
the
the ratios
ratios are
are based
based on
on historical
historical cost.
cost.
3.
3. Figures
Figures from
from the
the balance
balance sheet
sheet used
used to
to
calculate
calculate the
the ratios
ratios are
are year-end
year-end numbers.
numbers.
2005 Accounting 1/e, Terrell/Terrell 8 - 42
Limitations of Ratio Analysis
4.
4. Industry
Industry peculiarities
peculiarities create
create difficulty
difficulty
in
in comparing
comparing the
the ratios
ratios of
of a
a company
company
in
in one
one industry
industry with
with those
those of
of a
a
company
company inin another
another industry.
industry.
5.
5. Lack
Lack of
of uniformity
uniformity concerning
concerning what
what is
is
to
to be
be included
included in
in the
the numerators
numerators and
and
denominators
denominators make
make comparisons
comparisons
extremely
extremely difficult.
difficult.
2005 Accounting 1/e, Terrell/Terrell 8 - 43
End of Chapter 8